11/20/2008 @ 6:00AM

Deflation Is Here

Deflation is here and that’s something we haven’t experienced since the 1930s. Just this past summer, people were stewing about $150 oil and inflation. Now with oil at $53 a barrel that seems like ancient history, and people fear a deflationary spiral, whereby consumers stop consuming as they await cheaper prices. Repeat this ad infinitum, and you have the Great Depression. Certainly recent economic data points to cheaper prices. October’s Producer Price Index was down 2.8%, the lowest on record.

But it should be noted, there are deflations and there are deflations. Claudio Borio and Andrew J. Filardo of the Bank for International Settlements assessed the records of deflations going back to the 19th century and found that they have generally gotten a bad rap. In fact during the 19th and early 20th centuries, they write, deflation was generally not associated with persistent and deep economic malaise. All it takes is one Great Depression and an economic phenomenon’s reputation is ruined, it seems.

Borio and Filardo broke deflations into three categories, the good, the bad and the ugly. “Good” deflations can be linked to higher growth, bouncing asset prices and a nice rate of expansion of money and credit.

Unfortunately, the U.S. economy currently has the hallmarks of not-so-good deflation, including a significant increase in the ratio of credit to gross domestic product, large swings in property prices and an equity price boom on scale with the one that preceded the Great Depression.

While the Forbes.com Investor Team acknowledged that deflation is here, they differed on what it meant or how severe it might be. John Osbon, founder of Osbon Capital Management, says that the U.S. government is currently pricing deflation at -3.5% for the next two years. “This is just bad news all around,” he says.

But Gerard Klingman, an adviser with Raymond James, isn’t so sure we’re headed for a deflationary spiral. He is confident that the beleaguered Federal Reserve chairman is on the case and is ready to deal with the situation by any means necessary. Bernanke can be qualified as a deflation hawk.

In a 2002 speech before the National Economist’s Club, Bernanke addressed the issue: “That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation–a decline in consumer prices of about 1% per year–has been associated with years of painfully slow growth, rising joblessness and apparently intractable financial problems in the banking and corporate sectors. While it is difficult to sort out cause from effect, the consensus view is that deflation has been an important negative factor in the Japanese slump.”

At the time of Bernanke’s speech the post-dot-com era bear market had not ended. He told the club, “The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation,” and called the Fed a bulwark in that fight.

The strategy? Bernanke said, “when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more pre-emptively and more aggressively than usual in cutting rates.” That’s what Greenspan did, and what Bernanke is doing now.

Osbon: Deflation isn’t coming, it’s here. Just look at the TIPS (Treasury Inflation Protected Securities) spreads worldwide. The math is simple. Just take the 10-year bond yield and subtract the current TIPS yield and you have the inflation rate for the next x years, as priced by the market. In the U.S., the government bond market is pricing deflation at -3.5% for the next two years and -.67% for the next five.

Looking deeper into the G7, deflation is priced at -1.49% for the next 10 years for Japan and -.11% for the U.K. These are not predictions, these are real prices based on billions of dollars of position trades. Money speaks loud and clear on this topic. This is just bad news all around.

The oil tax cut is already spent, in my view, and therefore in the market prices. I hear from various economists that $62 oil, the official U.S. 2009 prediction, means about $110 billion more in the consumer’s pocket next year. Given the job loss and debt withdrawal symptoms affecting so many people, I suspect a large amount of that money will go to necessities like food, car and mortgage expenses.

I fear there is not much discretionary money left after the necessities are taken care of. True, not all who get the benefit are stretched, but I hardly think $110 billion in a $14 trillion dollar economy is enough to spend us back to prosperity.

Klingman: The only thing scarier than inflation is deflation. Certainly any significant decline in PPI is an indication that deflationary forces could be taking hold. Having said that, I think the likelihood of a deflationary spiral is small. While the government has left much to want in the way it has handled this crisis, I think Bernanke is totally focused on not letting this occur.

He is a student of the Depression and he will use all powers, including printing money, to avoid that outcome. The policy maneuvers used may ultimately create other problems down the road, but it will be worth it to reduce the risk of deflation.

Oil price declines are a major positive for the economy. Unfortunately in the short run they will be overshadowed by the rise in unemployment and the negative wealth effect of the decline in asset prices.

Klingman: I think the biggest implication of the “money-market bubble” is that at some point those assets will be looking to invest to get some return above 0% (the current real return for money-market funds after taxes and inflation). Some of this bubble is caused by an irrational fear about all investments, but some is also correctly motivated by a desire for businesses and individuals to have cash reserves as we enter a recession.

There is no question that at some point in this cycle those dollars will start to get invested in other asset classes (stocks, bonds, real estate) to try to achieve some real return. This will at some point create a “buying” panic just as we now have a “selling” panic.

Osbon: Hi guys–a continued or even larger money-market bubble would be against natural law, like water flowing uphill. My answer to the money-market bubble is an observation not a prediction. The simple reasoning is that money, like water, seeks its own level and cannot remain above or below that level for any length of time.

Money markets are ‘money,’ unlike stocks, which are ‘hope,’ and bonds, which are ‘promise.’ Money markets are a constant with which we can measure the variables of stocks and bonds. As such, money markets are among our most reliable observation points, unlike the fears, panics, predictions and scenarios that hold us enthralled right now.

Sure, the ratios of ‘money’ to markets can go higher but not for very long since such a raise would be such a strong incentive to invest. Market observations like this one are most valuable at extremes and declines, in my view. A tsunami of cash created by the wholesale flight from equities will eventually settle back to normal.

We don’t invest at OCM based on opinions like this, but we observe as many facts as possible in search of common sense.